Yes, there is a bubble out there! How do I know that? Well, think about it; if indeed the economy is as good as even Fed chair Powell suggested yesterday, why on Earth would they even dream of lowering interest rates, and why would they commit to not raising them till they see the whites of inflation’s eyes virtually pressing against the ends of their noses, if not the back of its head as it races right past them? There has to be something that has the Fed exceedingly concerned if they feel they have to stimulate an already humming economy.
So what could it be? Why indeed are they cutting rates and committing to keeping them low ad infinitum, amid an ongoing expansion? Well, it’s because they absolutely know that they have passed the point of no return.
You see, all of that stimulus coming out of the bursting of the mortgage bubble was so effective at inflating asset prices (just like it was coming out of the dotcom bubble), while wedding them (asset prices) to interest rates, that the Fed has boxed itself into the proverbial corner. And, worse yet — and this is the fundamental problem — it created yet another debt bomb that probably can’t be diffused; meaning, it more than likely has to detonate, intentionally or otherwise, before we can even begin to get back to something remotely resembling normalcy in the debt markets.
And of course the Fed fears, legitimately!, that that detonation will surely come at the hands of (or be blamed on) voting members who don’t pull every possible lever to delay it till the proverbial cows come home. But what will those proverbial cows be able to do??
The question of course is when, and how ugly will the next bubble-bursting be? The answer of course is we can’t know, and very!
Am I being an alarmist? Am I overstating the risk? Am I just one of those perennial pessimists?
Well, as for that last question, long-time clients (and blog subscribers) know that, if accused of anything, up till lately it would be of being the perennial optimist. As for the other two, I’ll let Moody’s and the IMF take those:
Moody’s this week: emphasis mine…
Investors have maintained a voracious appetite for high-yield debt this year, fueled by post-financial crisis quantitative easing, Moody’s Investors Service says in a new report. This has led to high-yield bond and leveraged loan volumes at historical highs, paving the way for unprecedented weakness in companies’ capital structures and erosion of their credit quality.
In the past year, loans have become more bond-like, balance sheets more concentrated in first-lien debt and investors have lost more control over debt terms and credit protections, Moody’s says. The forces of bond and loan convergence today are as strong as they were 12 months ago, when the rating agency raised concerns about how this trend is causing credit risk to worsen.
According to Moody’s analysts, investors will enter the next downturn more poorly positioned. Aggressive transactions and behavior have seen credit quality continue to deteriorate, with the percentage of first-time debt issuers rated B3 at about 40% today, or twice the percentage seen during the 2008-09 recession, adds Padgett. And as this cohort of companies contends with rating downgrades during the next downturn, the ranks of Caa issuers and defaults could also swell beyond 2008-09 levels.
Here’s from the IMF’s latest Global Financial Stability Report:
While easier financial conditions have supported economic growth and helped contain downside risks to the outlook in the near term, they have also encouraged more financial risk-taking and a further buildup of financial vulnerabilities, putting medium-term growth at risk. Indeed, the analysis presented in this report points to elevated vulnerabilities in the corporate and in the nonbank financial sectors in several large economies. Lower yields have compelled insurance companies, pension funds, and other institutional investors with nominal return targets to invest in riskier and less liquid securities. As a result, these investors have become a larger source of funding for nonfinancial firms, which, in turn, facilitated a rise in corporate debt burdens.
According to the analysis in this report, the share of debt owed by firms with weak debt repayment capacity is already sizable in several major economies and could reach post–global financial crisis levels in the event of a material economic downturn. Furthermore, low rates in advanced economies have spurred capital flows to emerging and frontier economies, facilitating further accumulation of external debt. The search for yield in a prolonged low-interest-rate environment has led to stretched valuations in risky asset markets around the globe, raising the possibility of sharp, sudden adjustments in financial conditions. Such sharp tightening could have significant macroeconomic implications, especially in countries with elevated financial vulnerabilities.
Institutional investors’ search for yield could lead to exposures that may amplify shocks during market stress: similarities in investment funds’ portfolios could magnify a market sell-off, pension funds’ illiquid investments could constrain their ability to play a role in stabilizing markets as they have done in the past, and cross-border investments by life insurers could facilitate spillovers across markets.
…central banks have adopted a more accommodative stance since the previous GFSR, and there has been a policy easing in economies representing about 70 percent of world GDP. Current and anticipated monetary policy accommodation has substantially boosted risk assets (Figure 1.1, panel 1). This change in policy stance appears to have been interpreted by financial markets as a turning point in the monetary policy cycle, following a period of rate normalization in some economies. The shift suggests that a sustained normalization of rates and central bank balance sheets may be more difficult than previously envisioned, especially in the context of weaker global growth and when other central banks continue to pursue quantitative easing.
Believe me, the above doesn’t begin to do justice to the full IMF report. If you’re so inclined, grab yourself a strong cup of coffee, and have a stiff drink ready for when you’re finished. Here’s the link…
Note to clients:
Our fundamental commitment here at PWA is to always have your portfolios positioned in a manner that captures the opportunities the financial markets have to offer, but first and foremost within the context of the risk/reward setup. Hence, the current hedging…
Have a nice weekend!